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CHAPTER 3 – Financial Statements3 - 4 Learning Objectives 1.The importance of preparing financial statements in accordance with a given set of guidelines or principles, and what the most important principles are 2.The fact that preparing accounting statements involves the use of judgement 3.How the basic financial statements for a company are constructed 4.The important information that can be found on a company’s balance sheet, income statement and cash flow statement 5.Why accounting income differs from income for tax purposes 6.How the capital cost allowance (CCA) system works 7.How different forms of investment income are taxed for corporations and for individuals.

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CHAPTER 3 – Financial Statements3 - 6 Importance of Understanding Accounting Accounting is an organized way of summarizing the activities of business.Accounting is an organized way of summarizing the activities of business. Internal and external users of accounting information rely on accounting information to make decisions.Internal and external users of accounting information rely on accounting information to make decisions. A strong understanding of accounting is required of financial managers because they use that information to make significant management decisions that will affect the future financial reports of the organization.A strong understanding of accounting is required of financial managers because they use that information to make significant management decisions that will affect the future financial reports of the organization.

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CHAPTER 3 – Financial Statements3 - 7 Accounting Principles Generally Accepted Accounting Principals (GAAP) are contained in the CICA Handbook and have the force of law in Canada.Generally Accepted Accounting Principals (GAAP) are contained in the CICA Handbook and have the force of law in Canada. The Income Tax Act (ITA) requires use of the CICA Handbook, except where specifically, the Act requires other treatment.The Income Tax Act (ITA) requires use of the CICA Handbook, except where specifically, the Act requires other treatment. –This has led to the practice of Canadian companies reporting to shareholders using CICA GAAP, and preparing separate financial statements for Canada Revenue Agency (CRA) Reporting of financial performance in a consistent manner over time and between firms enhances the usefulness of those reports allowing comparative analysis.Reporting of financial performance in a consistent manner over time and between firms enhances the usefulness of those reports allowing comparative analysis.

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CHAPTER 3 – Financial Statements3 - 8 Accounting Principles International Convergence Different countries have different accounting standards:Different countries have different accounting standards: –Canada – (CICA) Canadian Institute of Chartered Accountants Handbook –United States – (FASB) Financial Accounting Standards Board –Japan – (ASBJ) Accounting Standards Board of Japan Given the growing importance of international trade, integration of product and financial markets, there is a need for countries to move to a common set of accounting standards.Given the growing importance of international trade, integration of product and financial markets, there is a need for countries to move to a common set of accounting standards. –(IASB) London-based International Accounting Standards Board has been working with FASB and other accounting boards from numerous countries to work toward a common standard.

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CHAPTER 3 – Financial Statements3 - 9 Accounting Principles Recent Accounting Scandals ENRONENRON –Bankruptcy of one of the largest U.S. firms because of financial statement misrepresentation involving the external auditor (Arthur Andersen), management, and financial partners including Merrill Lynch, Citigroup, CIBC and others Other accounting/investment scandals involving WorldCom, Tyco, Bristol-Myers, Nortel and others demonstrate that the ENRON issue was not an isolated incident.Other accounting/investment scandals involving WorldCom, Tyco, Bristol-Myers, Nortel and others demonstrate that the ENRON issue was not an isolated incident.

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CHAPTER 3 – Financial Statements Accounting Principles Impact of Recent Accounting Scandals Investors base investment decisions and estimate the value of stock using accounting information.Investors base investment decisions and estimate the value of stock using accounting information. Recent accounting scandals where financial statements were found either to misstate the financial results, or later required revision has shaken the confidence of investors in financial markets.Recent accounting scandals where financial statements were found either to misstate the financial results, or later required revision has shaken the confidence of investors in financial markets. U.S. Congress in 2002 passed the Sarbanes- Oxley Act (SOX) in an attempt to restore investor confidence.U.S. Congress in 2002 passed the Sarbanes- Oxley Act (SOX) in an attempt to restore investor confidence.

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CHAPTER 3 – Financial Statements Accounting Principles Main Provisions Sarbanes-Oxley Act 2002 Creation of the Public Company Accounting Oversight BoardCreation of the Public Company Accounting Oversight Board –Register and inspect public accounting firms –Establish audit standards Separation of the audit function from other services provided by auditing firmsSeparation of the audit function from other services provided by auditing firms Improve governance standardsImprove governance standards –Separate board committees for finance and audit –External auditors must report to the audit committee –Audit committee independence (membership must be dominated by external directors) and financial expertise Requires the annual report to indicate the state of the firm’s internal controls and assess their effectivenessRequires the annual report to indicate the state of the firm’s internal controls and assess their effectiveness CEO and CFO must ‘certify’ that the firms financial statements “fairly present in all material respects, the operations and financial condition of the issuer”CEO and CFO must ‘certify’ that the firms financial statements “fairly present in all material respects, the operations and financial condition of the issuer”

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CHAPTER 3 – Financial Statements Organizing a Firm’s Transactions Bookkeeping Versus Accounting Bookkeeping is the mechanical act of managing and recording transactions.is the mechanical act of managing and recording transactions.Accounting is the application of GAAP principles and conventions to the bookkeeping data to produce financial statements that fairly represent the financial condition and operations of the economic entity.is the application of GAAP principles and conventions to the bookkeeping data to produce financial statements that fairly represent the financial condition and operations of the economic entity.

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CHAPTER 3 – Financial Statements Organizing a Firm’s Transactions Accounting Conventions: The Basic Principles The most basic principles of GAAP are: 1.The entity concept The accounting is for a specific economic entityThe accounting is for a specific economic entity 2.The going concern principle The statements are prepared on the basis that the economic entity will continue to operate into the future (hence liquidation values, for example, are not relevant)The statements are prepared on the basis that the economic entity will continue to operate into the future (hence liquidation values, for example, are not relevant) 3.A period of analysis Usually a fiscal year, although quarterly and monthly financial statements are also producedUsually a fiscal year, although quarterly and monthly financial statements are also produced 4.A monetary value Historical costs are used because the objectivity inherent in arms-length transactionsHistorical costs are used because the objectivity inherent in arms-length transactions 5.The matching principle Expenses incurred must be matched to the revenue earned in the period of analysis.Expenses incurred must be matched to the revenue earned in the period of analysis. 6.Revenue recognition Revenue is recognized when it has been earned (even though the cash may not yet have been received).Revenue is recognized when it has been earned (even though the cash may not yet have been received).

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CHAPTER 3 – Financial Statements Organizing a Firm’s Transactions Accounting Conventions: The Basic Principles The major conventions of GAAP are: 1.Procedures Assets are on the left, liabilities and equities on the right-hand side of the balance sheetAssets are on the left, liabilities and equities on the right-hand side of the balance sheet 2.Standards CICA HandbookCICA Handbook 3.Consistency The firm should consistently apply the same accounting principles over time to ensure comparability of financial statements from prior periodsThe firm should consistently apply the same accounting principles over time to ensure comparability of financial statements from prior periods 4.Materiality All significant information is disclosedAll significant information is disclosed 5.Disclosure The financial statements should fully and fairly disclose the firm’s financial position. Objectivity, consistency and conformity to GAAP are all aspects of full disclosureThe financial statements should fully and fairly disclose the firm’s financial position. Objectivity, consistency and conformity to GAAP are all aspects of full disclosure

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CHAPTER 3 – Financial Statements Preparing Accounting Statements The Balance Sheet The balance sheet is a financial ‘snapshot’ at one point in time (usually on the last day of the firm’s fiscal year)The balance sheet is a financial ‘snapshot’ at one point in time (usually on the last day of the firm’s fiscal year) It is an ‘inventory’ of what the firm owns (assets) and how those assets were financed (liabilities and owners equity)It is an ‘inventory’ of what the firm owns (assets) and how those assets were financed (liabilities and owners equity) –Left-hand side lists assets –Right-hand side list liabilities and owners equity –Top to bottom items are listed from most liquid, to least liquid

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CHAPTER 3 – Financial Statements Preparing Accounting Statements The Income Statement Also known as the profit and loss statementAlso known as the profit and loss statement Reports the income earned over a given period of timeReports the income earned over a given period of time –Usually prepared to report on one fiscal year –Can be prepared for a quarter of a year (3 months) or even a month Reports expenses incurred in order to earn that income (application of the matching principle)Reports expenses incurred in order to earn that income (application of the matching principle) Shows sales, expenses and net profit for a given period.Shows sales, expenses and net profit for a given period.

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CHAPTER 3 – Financial Statements Preparing Accounting Statements The Income Statement – Basic Structure Profit after tax may be retained in whole or in part to be reinvested in the firm and fuel the firm’s growth.

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CHAPTER 3 – Financial Statements Preparing Accounting Statements Changing Accounting Assumptions GAAP provides flexibility in the accounting treatment of things such as:GAAP provides flexibility in the accounting treatment of things such as: –When to recognize revenue –Capitalizing expenses as assets versus expensing expenditures –Rates of accounting depreciation Managements may have strong pressures on them to make the financial performance of the firm look as good as possible (indeed often their personal compensation may be affected by the accounting results)Managements may have strong pressures on them to make the financial performance of the firm look as good as possible (indeed often their personal compensation may be affected by the accounting results) –Consequently, managements may seek to change accounting assumptions (within the limits allowed by GAAP) to suit their needs and current circumstances facing the firm. Any change in application of GAAP must be disclosed in the audited financial statements and could jeopardize the audit opinion offered by the external auditors.Any change in application of GAAP must be disclosed in the audited financial statements and could jeopardize the audit opinion offered by the external auditors.

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CHAPTER 3 – Financial Statements Preparing Accounting Statements Tax Statements In Canada businesses must report to CRA and remit income taxes in accordance with the Income Tax Act.In Canada businesses must report to CRA and remit income taxes in accordance with the Income Tax Act. –They are required to use CCA instead of depreciation Firms in Canada also tend to produce a separate set of financial statements for shareholders, prepared in accordance with GAAP.Firms in Canada also tend to produce a separate set of financial statements for shareholders, prepared in accordance with GAAP. Because CCA is an ‘accelerated’ method of amortization, and because assets are often replaced more frequently than they are fully depreciated, thenBecause CCA is an ‘accelerated’ method of amortization, and because assets are often replaced more frequently than they are fully depreciated, then –Actual income tax liability in accordance with ITA using CCA is usually less than what is ‘estimated’ when reporting to shareholders. –This ‘inter-temporal’ difference in tax liability is called ‘deferred taxes’ and capitalized on balance sheets when reporting to shareholders. NOTE: deferred taxes DOES NOT mean that the firm hasn’t paid its full tax liability to the government…it has.

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CHAPTER 3 – Financial Statements Preparing Accounting Statements Accounting Income, Income for Tax and Economic Income Accounting Income –Net profit arrived at using GAAP and accounting depreciation Income for Tax Purposes –Net profit arrived at using GAAP and CCA in accordance with ITA Economic Income –The amount of funds a firm could withdraw from the firm at the end of an accounting period, and leave the firm in the same income earning position as it started the period Generally: Accounting Income > Tax Income > Economic Income –Accounting income is usually greater than income for tax because the CCA deductions are usually greater than accounting depreciation –Economic income is less than income for tax because CCA and accounting depreciation amounts are based on historical cost, and this understates the amount of money the firm must retain, to replace its asset base at higher replacement costs.

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CHAPTER 3 – Financial Statements Preparing Accounting Statements Cash Flow Statements Accounting profit may not reflect the cash flow reality facing the firm.Accounting profit may not reflect the cash flow reality facing the firm. The cash flow statement helps to provide a clearer picture of where cash is coming from and where it is going.The cash flow statement helps to provide a clearer picture of where cash is coming from and where it is going. Analysts are very interested in the cash flow realities of the firm because they realize that accounting profit is often not available to manage to pay bills.Analysts are very interested in the cash flow realities of the firm because they realize that accounting profit is often not available to manage to pay bills. There are two ways to calculate the cash flow statement:There are two ways to calculate the cash flow statement: 1.Examine changes in the balance sheet accounts 2.Add by non-cash items to net income.

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CHAPTER 3 – Financial Statements The Cash Flow Statement Net Income Plus Non-cash Items –Start with net income –Add back the non-cash items in the income statement (usually depreciation/amortization and deferred income taxes)

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CHAPTER 3 – Financial Statements The Canadian Tax System Federal and Provincial Governments in Canada tax individuals and corporations based on income earned.Federal and Provincial Governments in Canada tax individuals and corporations based on income earned. Corporations pay income taxes, and then, out of after-tax profit, distribute dividends to shareholders.Corporations pay income taxes, and then, out of after-tax profit, distribute dividends to shareholders. Dividends received by shareholders are taxed again as one form of personal investment income.Dividends received by shareholders are taxed again as one form of personal investment income. –Recognizing the double-taxation of dividends, dividends from Canadian corporations are given some partial relief through the ‘dividend gross-up, tax credit system’ –Dividends received from non-Canadian companies do not qualify for this special tax treatment.

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CHAPTER 3 – Financial Statements Corporate Income Taxation Corporate tax is paid at a ‘flat’ or fixed rate on ‘taxable income’Corporate tax is paid at a ‘flat’ or fixed rate on ‘taxable income’ –Small businesses (income of $300,000 or less) face approximately (the actual rate varies by province) a 20% tax on income (combined federal and provincial) Companies are free to chose their own taxation year (fiscal year) but once established cannot alter it without justification and approval.Companies are free to chose their own taxation year (fiscal year) but once established cannot alter it without justification and approval. Taxable income generally is income earned during the fiscal year less expenses incurred in order to earn that income.Taxable income generally is income earned during the fiscal year less expenses incurred in order to earn that income. –The income statement shows that variable costs and period overhead costs can be subtracted in determining EBIT –For tax purposes, the ITA requires that the Capital Cost Allowance system be used instead of accounting depreciation (amortization) –Interest expense on debt borrowed to earn income is generally deductible from earnings before the tax is determined.

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CHAPTER 3 – Financial Statements CCA Capital Cost Allowance (CCA) is the ‘depreciation’ method used by taxpayers in Canada when reporting business income to CRA Canada Revenue Agency for tax purposes.

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CHAPTER 3 – Financial Statements Importance of CCA to Financial Decisions Taxation issues must be explicitly addressed in each financial decision you make.Taxation issues must be explicitly addressed in each financial decision you make. Since CCA affects the net income from a business (and especially affects net cash flow), knowledge of the CCA system is essential for all business decision-makers.Since CCA affects the net income from a business (and especially affects net cash flow), knowledge of the CCA system is essential for all business decision-makers.

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CHAPTER 3 – Financial Statements CCA gives rise to a ‘Tax Shield Benefit’ to the Company CCA is a non-cash deduction from income that would otherwise be subject to income taxation.CCA is a non-cash deduction from income that would otherwise be subject to income taxation. As a result of the CCA deduction, taxable income is reduced.As a result of the CCA deduction, taxable income is reduced. This results in a savings in tax payable.This results in a savings in tax payable. The tax shield benefits is equal to: T(CCA)The tax shield benefits is equal to: T(CCA) t = corporate tax rate CCA = the dollar amount of CCA claimed A firm with a 40% corporate tax rate and a $2,000 CCA deduction will save $800 in taxes.A firm with a 40% corporate tax rate and a $2,000 CCA deduction will save $800 in taxes.

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CHAPTER 3 – Financial Statements Example: Consider two firms that report $10,000 in earnings before CCA and taxes, face a 40% tax rate. One firm has no CCA to claim, the other can claim $2,000 in CCA Company ACompany B Earnings Before CCA & Tax$10,000$10,000 CCA 2,000 0 Taxable Income$ 8,000$ 10,000 40%3,2004,000 Net Income$ 4,800$ 6,000 Add back non-cash expense2,000 0 Cash flow from Operations$ 6,800$ 6,000 Note that company A is better off by $800 because of the $2,000 non-cash deduction of CCA. That is the amount of taxes saved. If you look at net income, Company A appears to be worse off, however, that is only an accounting illusion!! Note that company A is better off by $800 because of the $2,000 non-cash deduction of CCA. That is the amount of taxes saved. If you look at net income, Company A appears to be worse off, however, that is only an accounting illusion!!

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CHAPTER 3 – Financial Statements CCA vs. Accounting Depreciation CCA like assets are grouped into pools or classeslike assets are grouped into pools or classes the CCA rate used in each asset class is setout in the regulations to the Income Tax Act and may or may not reflect economic wastage of the assetthe CCA rate used in each asset class is setout in the regulations to the Income Tax Act and may or may not reflect economic wastage of the asset no estimate of useful life or of salvage valueno estimate of useful life or of salvage value as long as the firm remains in existence, and assets remain in the pool, residual UCC values will remain in the pool.as long as the firm remains in existence, and assets remain in the pool, residual UCC values will remain in the pool. Accounting Depreciation choose the method that will best represent the economic wastage of the asset (declining balance, sum-of-the-year’s digits, straight-line, etc.)choose the method that will best represent the economic wastage of the asset (declining balance, sum-of-the-year’s digits, straight-line, etc.) individual assets are depreciatedindividual assets are depreciated estimate of useful life and salvage value is includedestimate of useful life and salvage value is included

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CHAPTER 3 – Financial Statements CCA Over Time - A Simple Example Assume you acquire a depreciable asset with a cost base of $100,000 and there are no other assets in this pool. The CCA rate for the pool is 10%. Note you are allowed only 1/2 the regular CCA rate on the net additions to the pool in the year of acquisition.

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CHAPTER 3 – Financial Statements Observations In the foregoing you can now readily see:In the foregoing you can now readily see:  CCA a firm claims changes each and every year on a ‘declining balance’-like basis  CCA provides the largest tax shields in the early years of the asset’s life  residual values remain in the pool long after the asset was acquired…this means that the firm will never fully recoup the original cost of the asset … as the firm’s asset base ages, cash flows generated from CCA will not enable the firm to replace the original asset.

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CHAPTER 3 – Financial Statements Disposition of Assets and CCA Capital Gains A taxable capital gain would occur if the firm sold a depreciable asset for greater than it’s original cost.A taxable capital gain would occur if the firm sold a depreciable asset for greater than it’s original cost. Capital Gain = Original Cost Base - Salvage Value

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CHAPTER 3 – Financial Statements Disposition of Assets and CCA Recapture of Depreciation If the salvage value of the asset exceeds the UCC of the pool there is a recapture of depreciationIf the salvage value of the asset exceeds the UCC of the pool there is a recapture of depreciation recaptured depreciation is subject to taxrecaptured depreciation is subject to tax Recaptured Depreciation = UCC pool - Salvage Value

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CHAPTER 3 – Financial Statements Disposition of Assets and CCA Terminal Loss When the last physical asset in the pool is sold and not replaced, the pool will be closed out.When the last physical asset in the pool is sold and not replaced, the pool will be closed out. If there is a positive balance remaining in the pool after disposition, that balance is called a terminal loss and is deductible from income in that year….it is a non-cash deduction just like CCA.If there is a positive balance remaining in the pool after disposition, that balance is called a terminal loss and is deductible from income in that year….it is a non-cash deduction just like CCA.

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CHAPTER 3 – Financial Statements CRA Form for Capital Cost Allowance An Example Assume you want to calculate the CCA for Class Six (10% CCA rate) given an opening UCC of $91,874; additions to the class of $32,880 and $25,000 as proceeds on disposals from the class. CCA = $9,581

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CHAPTER 3 – Financial Statements Personal Income Taxation Canadians are taxed on their world-wide incomeCanadians are taxed on their world-wide income The taxation year is the calendar year, starting on January 1 and ending December 31The taxation year is the calendar year, starting on January 1 and ending December 31 The personal tax system is a ‘progressive’ one…as taxable income increases, it is taxed at progressive higher rates.The personal tax system is a ‘progressive’ one…as taxable income increases, it is taxed at progressive higher rates. Table 3 – 7 on the following slide illustrates the top marginal tax rates in Canada on investment income (interest, dividends and capital gains).Table 3 – 7 on the following slide illustrates the top marginal tax rates in Canada on investment income (interest, dividends and capital gains). (Please see the following slide with Table 3 -7)

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CHAPTER 3 – Financial Statements The Canadian Tax System Personal Income Taxation

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CHAPTER 3 – Financial Statements The Canadian Tax System Personal Income Taxation of Investment Income Investment income can be earned by investors in three different forms: –Interest –Dividends –Capital gains

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CHAPTER 3 – Financial Statements Taxation of Interest Income Interest income is taxed at the person’s personal marginal tax rate (the same rate that employment and business income is taxed at)Interest income is taxed at the person’s personal marginal tax rate (the same rate that employment and business income is taxed at) We use the ‘marginal’ rate because when a person invests, they are seeking to add to income in the future…that added income will face the marginal tax rate.We use the ‘marginal’ rate because when a person invests, they are seeking to add to income in the future…that added income will face the marginal tax rate. All sources of interest must be claimed each calendar year (both cash interest received, and interest income that has accrued)All sources of interest must be claimed each calendar year (both cash interest received, and interest income that has accrued) –Accrued interest is interest that has been earned, but not yet received (for example, from compound interest Canada Savings Bonds that have yet to be redeemed) (Please see the following slide with Table 3 -6)

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CHAPTER 3 – Financial Statements Taxation of Interest Income Ontario Tax Rates – Interest Income Interest income is taxed at the investor’s personal marginal rate. All interest income, whether received in cash or accrued is subject to tax in each tax year.

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CHAPTER 3 – Financial Statements Taxation of Dividend Income Dividends from Canadian companies are taxed using the ‘gross-up, tax credit system’Dividends from Canadian companies are taxed using the ‘gross-up, tax credit system’ –Cash dividends are grossed up by 45% and this total amount is included in taxable income –A federal dividend tax credit of 18.97% and provincial dividend tax credit of 6.5% (Ontario) is deducted from taxes that would otherwise be payable. –The effect of this system is to effectively reduce the marginal tax rate applied to dividend income. (Please see the following slide with Table 3 -6)

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CHAPTER 3 – Financial Statements Taxation of Capital Gain Income Only realized capital gains are taxedOnly realized capital gains are taxed –This is a very important feature for high income earners who do not need investment income to fund their everyday living expenses…they can afford to wait to sell their investments indefinitely…and indefinitely delay paying taxes on the capital gains 50% of a realized capital gain is subject to tax at the person’s marginal tax rate.50% of a realized capital gain is subject to tax at the person’s marginal tax rate. Capital losses can only be used to offset taxable capital gains.Capital losses can only be used to offset taxable capital gains. (Please see the following slide with Table 3 -6)

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CHAPTER 3 – Financial Statements The Canadian Tax System Personal Income Tax Rates – Capital Gains At the higher marginal tax brackets, taxpayers will prefer to receive their investment income in the form of capital gains because they are taxed at a 23.2% marginal rate. Only ‘realized’ capital gains are subject to tax.

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CHAPTER 3 – Financial Statements Summary and Conclusions In this chapter you have developed: –A basic overview of accounting statements –An understanding of the importance of generally accepted accounting principles –An understanding of the Canadian tax system and the importance of tax considerations in financial decision-making.